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Monday, 9 February 2015

Islamic Finance: What is it all about?

Socio-economic justice is one of the most significant characteristics for social, political, economic and other realms of human interaction. The goals of socio-economic justice and equitable distribution of income and wealth are integral parts of the moral philosophy of Islam. One of the socio-economic reforms made by Islam was the prohibition of interest through the establishment of interest-free Islamic finance.

In this article, I will briefly explain how an interest-free Islamic finance based on profit and loss sharing will help bring about sustainable economic growth and innovation and thereby pave the way for a prosperous world.

Saving and investment

Saving and investment are two of the most important determinants of economic growth and development. The classical belief that saving is determined by the interest rate is refuted by Keynes. According to him, aggregate saving is governed by the aggregate income. Empirical evidence does not show any significant relationship between saving and interest rates. In fact, interest puts a limit to the marginal efficiency of capital, which does not rise to its optimum level, thus all the resources available cannot be fully utilised. This causes a fall in investment.

Interest is also considered as a cost of production and hence the price of the product is adjusted to it, so consumers are affected because of the higher prices of goods and services. In fact, in an interest-free Islamic financial system, savings are likely to be promoted. First of all, in the profit sharing arrangement the return to capital will include “reward for both savings and risk-taking,” which means a higher return to financiers than in an interest-based system. This means if higher returns or higher income determine the level of savings, people will save more in a share economy than in an interest based economic system. Secondly, profit-sharing in mass production between employer and employees will, on average, give higher income to the employees who constitute the majority of the population.

On the other hand, in an interest-free scheme, where both the financiers and the investors have a stake in the return of their investments, low returns may not deter them from investing, as neither the investors nor the financiers will be better off or worse off, one at the cost of the other. In fact, both can be worse off by not investing. In the profit sharing system, it is innovative enterprises that are likely to set constraints to investment rather than finance. This is because capital does not impose a limit to investment such as in the interest based system. Thus, innovative entrepreneurs who are ready to develop new profitable investments will always raise funds for such ventures.

Unemployment and inflation

Interest rate causes unemployment and inflation in several ways. When it is high it also makes cost of production high, causing a decline in investment and in some cases closure of production units, resulting in retrenchment of workers. Alternatively, producers increase the prices of goods and services to cover the increased cost, thereby causing inflation. On the other hand, when interest rate is low the tendency is to switch to capital intensive method of production, thereby causing technical unemployment due to the replacement of labour by machinery.

Low interest rate encourages borrowing for consumption, which usually increases the demand for goods and services, hence resulting in demand pull inflation. Martin Weitzman has stated that all the mechanisms used in solving the problem of stagflation have failed. He said that profit-sharing is the best form of policy for combating unemployment and inflation. He further mentioned that profit-sharing represents an easy way of building into the system the kind of natural resistance to unemployment and inflation that could really disarm stagflation at its source.

Interest and stability

It may be asserted that interest is one of the most destabilising factors in the capitalist economy. Milton Friedman, posing the question, “What accounts for this unprecedented erratic behaviour of the US economy?” responds by saying, “The answer that leaps to mind is the correspondingly erratic behaviour of interest rate.” Erratic fluctuation of the rate of interest creates erratic shifts in financial resources between users, sectors of the economy and countries, causing erratic movements in the loan based investments, commodity and stock prices and exchange rates. The high degree of interest rate volatility has injected great uncertainty into the investment market, which has had the effect of driving borrowers and lenders alike from the longer end of the debt market into the shorter end, thus fundamentally altering the investment decisions of businessmen.

Islamic finance based on profit and loss sharing (PLS) is likely to be more attractive for both the firms and the financiers. This is because PLS system promises leverage benefits to the firms free of risk and a return higher than the rate of interest to the financiers. Fluctuations in the rate of profit on equity under Islamic finance are likely to be smaller than the rate of profit on equity under the interest finance and that PLS operations may have a smaller destabilising potential for the economy as a whole compared to financing on interest. Another factor that makes Islamic finance more profitable than interest-based system is that the burden of the risks on the part of the investors is reduced. This encourages entrepreneurs to be more innovative and venture into high risk projects which are usually characterised by high profitability. Furthermore, the spirit of mutual co-operation and sense of ownership and responsibility promoted by profit-sharing results in efficient use of resources and increased output in turn increases profit.

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